Weekly Economic Update 06-29-2018

President Trump’s Plan to Win the Trade War

Donald Trump campaigned and won the election to become our 43rd President on his promise to bring jobs back to the midwestern region of our country. During his inauguration speech, President Trump repeatedly pledged he would employ a protectionist strategy to help America’s farmers and to bring manufacturing jobs back to America. In the year following his election, President Trump began implementing tariffs and made threats of creating additional tariffs if our trading partners didn’t remove their barriers allowing equal and equitable trade.

President Trump believes he can easily win a trade war and he may very well achieve his goal but trade wars can be a slippery slope. If a trade dispute cannot be resolved quickly, it can easily escalate into a full-blown trade war. Full-blown trade wars often turn into actual wars. Otto Mallory (1881-1956), who wrote the book Economic Union and Durable Peace, confirms this view when he said, “When goods don’t cross borders, soldiers will.” Given the recent chest-thumping of some of the major military superpowers, it appears Mallory’s opinion is well understood.

Those on both sides of the political fence seem to share one view – neither seems to understand if President Trump has a master plan to win a trade war or if he is winging it. I must admit I found myself equally confused about the path President Trump is guiding our country down. Some of his policies seem to justify his long-term plan, while his other policies seem rather questionable. It also appears to me that President Trump hasn’t shared his plan with too many of those in Washington D.C., as both parties seem to be scrambling to adapt to his leadership.

I recently decided to see if I could figure out if President Trump is flying by the seat of his pants or if he does have a master plan. To take an objective and hopefully impartial view, I have chosen to cast aside all opinions I have about President Trump, both political parties, the mainstream media and the analysts who cover politics. I have also read “Trump: The Art of the Deal,” to familiarize myself with President Trump’s negotiating tactics.

To win a negotiation, the side which will be victorious needs to have something of great value, the willingness to walk away from the negotiating table and time to outlast their opponent. Having time to wait is the most critical aspect of winning a negotiation. As long as America can outlast her foreign trading partners, we can win. Once you understand this concept, you will understand how President Trump can win any negotiation he chooses. However, winning a trade war isn’t risk-free. Should President Trump fail, he could create the final push causing the world to plunge into a recession, or worse—war.

The first move the Trump Administration made was to push through a tax cut. I was opposed to this because tax cuts are a form of fiscal stimulus. It is rare to have a tax cut passed when the economy is in an expansion because the fiscal stimulus of the tax cut isn’t necessary to keep the economy growing. Tax cuts are typically saved for recessions to help lift the economy out of a slump. To put the tax cut into context, the last time a tax cut was passed during an expansion, to the best of my research, was over 50 years ago.

My original view of the tax cut was it needed to get passed by the end of 2017 to help the Republican Party win the upcoming 2018 mid-term elections and stay in power. The fiscal stimulus provided by the tax cuts would provide enough boost to encourage voters to support the Republican Party.  While this view is valid and was supported by the mainstream media, I have since changed my opinion. Looking at the tax cuts from the view of an upcoming trade war has changed my entire perspective.

Recall that one of the keys to winning a negotiation is to outlast the opposing party. In other words, from an economic perspective, our economy needs to be strong enough to outlast the economy of any nation President Trump is attempting trade renegotiations.

The tax cut was intended to increase the take-home pay of most Americans. Due to the progressive design of our tax system, half of all Americans pay very little or no Federal income tax, so most of the tax cut went to the wealthy. The other tax-cut beneficiaries were U.S. corporations who received a very generous reduction in their tax liability.

Many believe American corporations needed the tax cut to be competitive with foreign corporations but due to the ability to deduct certain expenses, most American corporations were already paying a below-average tax-rate. After the tax cut was passed, Secretary of the Treasury Steven Mnuchin spoke to a group of American CEO’s whose companies were beneficiaries of the tax cut. He asked the room of CEO’s how many of them planned to reinvest the tax cut into capital spending and wage increases, and only a few said they would.

Sure enough, many of the corporations who were beneficiaries of the tax cut used it to purchase their stock back in order to boost executive compensation, rather than spend the tax cut into the real economy. The decision to spend the tax cut on corporate stock buybacks will later prove to be a huge mistake. President Trump wanted corporations to use the tax cut to boost wages and to increase capital expenditures so he could buy more time to win the trade wars.

Imagine for a moment that corporate beneficiaries of the tax cut spent their windfall on capital expenditures and wage increases. The wage increases would likely lead to increased consumption and the capital expenditures would likely lead to increased employment. The combined demand from both sources would likely create a strong economic boost to give President Trump a strong position from which to negotiate. With the U.S. economy booming, our foreign trading partners would be forced to cave to his demands.

When looking at the tax cuts from the perspective of a tool to continue the economic expansion to win a trade war, the tax cuts make sense. Unfortunately, corporate executives decided to use their windfall in a way that does not boost economic output. The other problem with the tax cuts is they are deficit-financed, meaning the United States has to borrow the money for the tax cuts from the same people who are receiving the tax cuts.

Deficit-financed tax cuts have a short economic lifespan, especially in overly indebted economies. My original opinion was this tax cut would have a six-month lifespan due to the actions by the Federal Reserve. I was right. Most American started seeing the effects of the tax cuts in their February paychecks. The first quarter’s economic data showed signs of promise and the second quarter estimates are looking strong.

The Monetary Base or the total amount of money circulating in the economy, has fallen below its January 2018 levels, which means the economic boost from the tax cut has been flushed from the economy. Commercial and Industrial lending is starting to roll over after getting a small boost from the tax cut. Even bank credit, which includes bank loans, their investments, government securities and other securities, is also starting to roll over. The M2 Money Supply received a brief boost, but I expect in the weeks to come it will also roll over and resume its deceleration.

Due to the lagging effects of fiscal stimulus, the tax cuts should continue to show economic growth for the next month, maybe two, but after that, all signs of the tax cut should rapidly fade. While President Trump has tried to stack the deck in our favor, the one entity that has the power to sabotage his plans is the Federal Reserve.

The Federal Reserve is actively tightening the money supply by raising the Federal Funds rate and through Quantitative Tightening, which reduces the amount of excess reserves in the banking system. The Fed has suggested there will be two more rate hikes this year which will remove $120-140 billion from the money supply. Starting next month, the Fed will increase their Quantitative Tightening, or balance sheet roll off, to $40 billion per month, then increase it to $50 billion per month starting in October.

Ultimately the winner of the trade wars will be the country with the economy that can outlast all the others. The Federal Reserve is actively undermining President Trump’s plan to win the trade war and it is unlikely they will stop. The Federal Reserve is trying to fight inflation, but tariffs lead to higher prices, which appears inflationary. As prices rise as part of the natural effects of a trade war, the Fed will likely step-up their efforts to combat rising prices and push our economy, and the rest of the world, into a recession. If the tax cuts were part of President Trump’s master plan to win, he better hurry because the Fed is the most likely to win by pushing our economy into a recession.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

Equity markets fell on news the trade war is escalating. The markets make the news, not the other way around. Liquidity is drying up because the tax cuts have largely passed through the economy. The rate hike from two weeks ago is likely hitting the economy, in addition to the Fed’s monthly balance sheet unwind.

Today’s move down was not based on heavy selling or panic, based on trading volumes. Trading volumes were double what they have been lately, but a doubling of low volume gets you closer to average volume. Volatility moved higher, which it should be doing, and stock prices fell without much trading activity.

Treasury yields were down a little but short-sellers are holding strong to their positions that inflation is coming. New home prices fell $30,000 last month which is hardly inflationary.

Physical gold dropped as well as the mining stocks, which is good news. Gold prices are hovering just over the top end of my targeted “Buy Zone.” I’m hoping to see prices get down to the bottom of the range, so we can start buying in.

Soybeans continue to push agricultural commodity prices lower. What’s weird is that China placed a 10% tariff on Soybeans and prices have fallen more than 10%. Normally tariffs lead to higher prices, so traders essentially have caused Soybean prices to drop enough where China can buy them at a lower price than before the tariffs. Go figure?

  1. What happened to the stock market on Tuesday?

Equity markets tried to rebound after yesterday’s big sell-off. In months past, a sell-off like yesterday’s have proven to be strong buying opportunities. Today, it wasn’t a strong opportunity, because stock prices didn’t rise very much. It’s almost as if the Fed is draining liquidity from the economy and the tax cut has already filtered through. If that is the case and the Fed is winning, stock prices should continue to fall.

The Dow closed for the second time under its 200-day moving average, which is rather rare. If the Dow fails to find strength, look for sellers to push the Dow down.

The 2-year Treasury auction saw lower yields, which is unusual since 2-year yields have been rising the past 6 months. This shows there is demand for bonds at the low end of the yield curve. Long-term bond yields dipped slightly and are likely to continue falling. This week alone there will be 200 billion of Treasuries auctioned, which also drain liquidity from the economy.

Heat and more heat is destined for the growing region, which shouldn’t be good for the recently planted crops.

Physical gold fell into the “Buy Zone” today. The gold miners fell into the “Buy Zone” but found some buyers. I don’t think this is the bottom yet, but we are ready to roll. One expert I follow says to wait until after July 4th, which is a seasonably strong time for gold. We’ll be watching and waiting…

  1. What happened to the stock market on Wednesday?

US equities tried to erase the last two days of trading this morning but ended strongly in the red when stock prices took a hard reversal late morning. With the quarter about to come to an end, I am wondering if this apparent lack of liquidity is due to the Fed, corporate share buybacks for the quarter ending, or both.

Yields dropped across the board and the five-year Treasury auction saw the lowest yields in six-months. Momentum on Treasuries is about to turn upwards, which could lead to the massive short-squeeze I’ve been expecting.

Physical gold continues to fall. We are looking at the $1,246-48/oz range to see if prices hold. If prices fail to hold that level, I expect gold to drop to $1,200-15/oz. The mining stocks are showing signs of weakness and I expect them to drop a bit more before we look to buy. I want to see physical gold firm before buying the miners.

I found out China dropped their tariffs on Soybeans for other countries and raised ours, which explains the price drop on US commodities. Agricultural commodities have taken a three-wave move down, which follows “Elliott Wave Theory.” I’m expecting this to be the bottom of the move for now, but we’ll see. There’s a huge heatwave hitting the growing region with low precipitation, which shouldn’t be good for emerging crops.

  1. What happened to the stock market on Thursday?

Today’s move was very technical in nature, as last night market technicians started pointing out that the major indices are on the cusp of a larger move down if key support levels weren’t held. The S&P 500 tried to close above its 50-day moving average, but closed below, with all eyes on 2,700 as the level to watch. The DJIA tried to get back above its 200-day moving average but closed below for the fourth day in a row – a bearish indicator.

The volatility index or VIX, is showing signs of going straight up as volatility is rising. Should key technical levels get broken and volatility breaks loose, stock prices will rapidly drop.

Today’s 7-year Treasury auction saw decent demand with lower Treasury yields. Eleven major banks announced today they will be spending $100 billion over the next quarter on share buybacks. They spent heavily last quarter and bank stocks fell, which is a testament to how strong the Fed’s liquidity drain is. Bank stocks are on the edge of a technical cliff, so this announcement should help stock prices in the short run. Keep in mind, the Fed, barring any further rate hikes, will drain $120 billion in excess reserves from the banks next quarter.

I am thinking about how closely 10-year Treasury yields are correlated to bank stocks, and I will share with you a chart this week illustrating the correlation. Rather than investing their cash holdings in more lending, banks are clearly choosing to buy their shares back. When all this money dries up, Treasury yields will plummet and likely see new all-time lows during the next recession.

Physical gold continues its slide and market technicians are saying this is a potentially ugly move that could see physical gold drop back to its 2015 lows. Classical chartist Peter Brandt says $1,236/oz is the level to watch – I have previously stated $1,246-48/oz were the bottom end of my range. Today physical gold hit my target and showed no signs of slowing. If gold continues to fall, the mining stocks should as well. This just sets up a much larger opportunity going forward.

The major heatwave that is hitting the Midwestern growing region is getting hotter by the day with precipitation expected to be below average. Congress is working on a #Farmbill right now, which experts say will boost agricultural commodity prices. For the moment, a bottom in agricultural commodities appears to be in place.

  1. What happened to the stock market on Friday?

As Asian markets opened, U.S. indices futures jumped on no news. A month or so ago when the major indices were struggling to get over their moving averages, someone pushed them over in overnight trading. The last time the indices got pushed over their moving averages, a mini-rally formed. Not this time.

While everyone was focused on stocks rising this morning, I was watching the VIX or volatility index. It is on the cusp of exploding to the upside, but it had to confirm its moving averages first. It did that today. As I thought, stock prices quickly faded as volatility rose.

The S&P 500 closed at its 50-day moving average with strong selling – a sign of weakness. The Nasdaq-100 closed below its open. The DJIA closed below its 200-day moving average for the fifth day after being catapulted over its 200-DMA last night.

Bond yields were up slightly but they were also an indication this was a false rally in equities. Typically when stocks rise, yields have been rising as well. It wasn’t until late trading that yields rose and stocks fell. Bond investors aren’t buying the growth narrative.

Physical gold hit the bottom end of my target range but other experts indicate the bottom might be a little lower. All the signs are pointing to a potential near-term rally in gold, which I am looking forward to seeing. At this point I am just looking for confirmation this is a directional change and not a short-term technical bounce.

Agricultural commodities had a strong day and seemed immune to the stock markets late-day drop. This is a positive sign as a massive heatwave is coming to the growing region for the next week or two.